Nasdaq Proposes New Order System for ETFs

Nasdaq, as the No. 2 marketplace for ETFs behind the New
York Stock Exchanges electronic platform, NYSE Arca, is
known for putting more ideas out there, and right
now, its got a proposal pending with the SEC for a
new type of order for U.S. equity ETFs called an iNAV
Pegged Order. If the SEC gives it the nod, it will be a
first of its kind.

With U.S. equity ETFs, their iNAVs, or intraday net asset
values, are automatically adjusted every 15 seconds based on
the current market value of the stocks in their portfolios.

What the Nasdaq is proposing is that investors be allowed to
put in orders pegged to a U.S. equity ETFs
most recent iNAV. As the iNAV changes, so move the iNAV
Pegged Orders, the Nasdaq stated in its SEC filing, made
on October 12. Nasdaq also noted a Pegged Order may have
a limit price beyond which the order shall not be
executed.

And the point of instituting this order type, Nasdaq said in
its pitch to the SEC, is that relative to the current
intraday order entry/execution order types, the iNAV Pegged
Order type would allow certainty of execution with a greater
correlation to the ETFs fair value for those seeking to
invest on a more informed basis.

I think its a good idea, says Michael
Rawson, an ETF analyst at Morningstar in Chicago.
Its like a limit order, but pegged to the current
iNAV of a fund, and that makes sense, he says.

But Dave Nadig, the director of research at IndexUniverse in
San Francisco, sees a number of potential problems. I
think its got its heart in the right place, but the
devils in the execution, he says.

First of all, it applies only to the ETFs that are strictly
invested in U.S. equities because those are the only ones where
its possible to get an intraday NAV that is close
to being accurate, he says. Therefore, the ETFs that hold
some mix of U.S. and international stocks, or stocks and bonds,
would be excluded, and that narrows the list of eligible ETFs
to a few hundred, he notes.

Secondarily, most ETFs trade at a spread around iNAV, but
not right at iNAV. If, say, the iNAV is 100, its very
common for the ETF to be quoted at 99.90 to the seller or
100.10 to the buyer, he says. And Nadig notes, market makers
will want to sell at iNAV plus 10 cents because
thats how the market works; thats how they make
their money. He adds that the risk is that you could
miss your trade because youre being very picky and want
to get your ETF shares at iNAV.

Whats more, Nadig says,iNAV isnt
perfect. He points out that theres no way to keep
iNAV from responding to any kind of bad data that gets fed
into it, such as a bad print on one stock out of
50 in an ETFs basket.

In its filing, Nasdaq said that in the event that
the iNAV data feed for a particular ETF were to be
compromised or temporarily stopped being disseminated, the
use of the iNAV Pegged Order type for that ETF would be
suspended, and orders already in the system would
be cancelled.

But, what if it doesnt get cancelled in time,
and it gets hit? asks Stephen OGrady, who was the
partner in charge of ETF trading at Kellogg Capital Markets,
before it was sold to Knight Capital Markets in October 2010.
He is now a consultant based in Mountain Lakes, New
Jersey.

OGrady notes that if market makers either buy
or sell at iNAV, they cannot make any money.
Thats because market makers make their profits selling
or buying above or below iNAV, and they then hedge their bets
by buying or selling the underlying stocks.

Its the obligation of the exchanges to see
that the public is getting treated fairly, but the problem
is: What is the incentive for the market makers? Theyre
the ones who have the money at risk, not the exchange,
he says.

But, he also notes most of the complaints about the
ETF market are that market orders get screwed. Once the
market is open, things can move very quickly, he
says. Under the current system, his advice is:
Dont put market orders in, and if you do, be
prepared to get a price youre not happy with.

So far, no comments have been filed, but the comment
period is still open though tomorrow, November 8.

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